Economic Growth Will Continue: Entering the Next Stage

I continue to be more optimistic about the path of economic growth that is occurring in the United States.  There are still potential “bumps-in-the-road” like the recession in Europe (http://seekingalpha.com/article/317268-issue-number-1-for-2012-recession-in-europe) and the slowdown in the economic growth of China.  Still, the economic recovery in America goes on.

On the positive side, I am encouraged by the fact that bank lending is getting stronger. (http://seekingalpha.com/article/499921-loan-growth-continues-to-pick-up-at-commercial-banks) The important signal, to me, coming from the banking data, is that the health of the banking system is improving.  Although many commercial banks still have major problems, the system, as a whole, is getting stronger and this is allowing for greater loan growth.  In the first quarter of 2012, the annualized rate of growth in loans and leases at commercial banks was almost 6.5 percent.  This is good.

Today, we got some encouragement from the housing industry: “Building permits in March 2012 were at a seasonally adjusted annual rate of 747,000, up 4.5 percent from the revised February rate and up 30.1 percent from March 2011. Housing starts in March 2012 were at a seasonally adjusted annual rate of 654,000, down 5.8 percent from February’s revised estimate but up 10.3 percent from March 2011.”  The decline from February to March was due to unseasonal strength in the housing area because of the very mild winter weather experienced this year.  The year-over-year rate for March is much more indicative of the pick up in this construction.

The economic recovery is continuing. 

On the negative side, I still believe that economic growth will continue to be anemic compared with historical trends.  As I have argued before (http://seekingalpha.com/article/469671-gdp-growth-the-road-ahead-and-the-investment-climate), I am expecting economic growth to be in the 2 percent to 3 percent range, but I believe growth will be closer to the former figure than the latter.

There are several reasons for this.  One reason is that under-employment will still remain high.  I don’t care that much about un-employment in the current case because under-employment has remained in the 20 percent range and as long as this condition exists in the United States, consumer spending will remain relatively weak.  Furthermore, this condition just adds to the pressure for families to deleverage and get out from under the debt loads they have been carrying.  This helps to account for the very weak consumer loan data at commercial banks.

There are also other reasons for only moderate economic growth.  State and local governments still have a ways to go before they become a positive force in the economy again.  With declining property values and huge problems in the pension area, these governmental bodies will continue to slash payrolls and other budget items in an effort to return to some form of fiscal prudence. 

And, there is one other area that I believe will continue to weigh on the economy over the near future.  I have written from time-to-time about the impact the last fifty years of credit inflation has had on the productive capacity of the United States manufacturing base.  Credit inflation is not good for producing improvements in the productivity of capital.  And, if the productivity of capital is not increasing then economic growth is going to suffer.

The effects of this credit inflation are picked up in the utilization of our productive capacity.  In the 1960s, capacity utilization in the United States was well in excess of 90 percent.  There has been a secular decline in capacity utilization in America as the peak of every business cycle over the past fifty years has been at a lower utilization of our capital base. At the last cyclical peak we were using slightly more than 80 percent of our capacity.  At the present time capacity utilization is increasing as the economy has expanded since June 2009, but we remain around 78 percent. (The March figure of capacity utilization of 78.6 percent was released this morning.)

I believe that the economic growth rate of the United States will remain below the post-World War II level of about 3.2 percent as the rate of capacity utilization continues to lag.

The problem with this is that this growth rate will not accelerate as potential inflation problems arise. 

This inflation problem is raised by Francesco Guerrera in the Wall Street Journal: “Sowing Seeds of the Next Major Crisis.” (http://professional.wsj.com/article/SB10001424052702304818404577347641050572260.html?mod=ITP_moneyandinvesting_0&mg=reno64-sec-wsj)  For one, the Federal Reserve has pumped massive amounts of reserves into the banking system.  This was done to protect against a greater financial crisis than was experienced and to prevent the banking system from collapsing.  The post-crisis problem is about the ability of the Fed to remove these reserves from the banking system without jump-starting another crisis. But the question is, if the commercial banks have all these excess reserves (about $1.5 trillion of them) and if the banks are beginning to lend again, where is all this money going to go?   

If the economy will not grow much faster, the answer is that the money will force up prices.  These are not “normal” times.  As Guerrera states, “Unfortunately, there is little ‘business as usual’ around. Not at a time when Europe is in recession, the U.S. in the throes of an anemic recovery and even China is slowing down. And not when bank balance sheets are saddled with decaying leftovers of the crisis—asset-backed securities, bad loans and litigation—and vital parts of the system, such as derivatives trading, are gummed up by fears of new regulations.”

This scenario has “stagflation” written all over it.   The economy will continue to grow, but maybe we should start to prepare for our next series of problems.

Loan Growth Continues to Pick Up at Commercial Banks

My report on bank lending last month had the headline, “Finally, some real loan growth at the banks.” (http://seekingalpha.com/article/426601-finally-some-real-loan-growth-at-the-banks)

Well, loan growth has continued through March.  Loans and leases at commercial banks increased by over $10 billion in March, bringing the total rise in loans and leases up to $95 bullion for the first quarter. 

The interesting thing is that this increase occurred predominately in the “small” banks in the country, the roughly 6,265 banks that comprise the Federal Reserve’s definition of small.  The “large” banks are the largest 25 domestically chartered commercial banks in the country.  A total of $79 billion, or, 83 percent of the increase in loans and leases at commercial banks in the United States over the first quarter, came from these “smaller” banks. 

This is certainly good news.  Economic growth in the United States had been rising since June 2009, but the growth rate has been pretty tepid.  Two reasons for the slow growth were that many individuals and businesses in America were deleveraging and the commercial banking system was trying to get itself in order given all the bad assets that were on the balance sheets of the banks. 

The concern has been that as long as the banks were re-structuring and individuals and businesses were attempting to lessen the debt on their balance sheets, economic growth would remain shaky.  For things to feel more secure, banks would have to start lending again. 

Loans and leases at commercial banks were up 4.7 percent, year-over-year, in March.  Almost two-thirds of this growth came in the past six months, and over one-third of the growth came in the last three months.  This is encouraging.

In the smaller commercial banks, the largest increase in loans came in the residential real estate area.  Residential loan growth rose by more than $31 billion in the past quarter and about $53 billion in the past year. 

The interesting “turn-around”, however, was in commercial real estate loans.  For the year as a whole, commercial real estate loans at the “smaller” banks were down by almost $13 billion, but, for the last quarter they were up by more than $14 billion, a $27 billion reversal. 

Commercial real estate loans were still down in the largest 25 banks by over $5 billion in the quarter, but on the whole, the strength shown in this area is ‘hopeful” and worthy of continued watching.

Business loans at commercial banks (commercial and industrial loans) have been up year-over-year for several months now, but the real strength has been at the largest banks.  For example, year-over-year, commercial and industrial loans at the largest 25 banks in the country were up by almost $105 billion compared with an increase of $42 billion at the smaller banks. 

However, in the first quarter of 2012, business loans at the largest banks rose by $25 billion as compared to a $24 billion increase in the “smaller” banks. 

This, to me, is a good sign for economic growth.  Although it may not translate immediately into much faster growth, I take this strength in lending as protecting against a downside fall-off.

Consumer lending was particularly weak in the first quarter of 2012 as consumer lending fell by more than $2 billion.  This would seem to indicate that consumers were still consolidating and/or reducing their debts and were not out spending.  This, of course, can help to account for the continued weakness in economic growth. 

Overall, the information coming from the banking system is encouraging.  Commercial bank lending is increasing and it is increasing in both the business and real estate sectors of the economy.  Furthermore, bank lending is showing more strength amongst the “smaller” banks in the country.  This is good news to me not only because it might indicate that “main street” is beginning to show some life, but this could also be an indication that the health of the “smaller” banks is improving. 

One final point has to do with the cash balances carried by the commercial banks.  In March 2011, commercial bank cash holdings averaged $1,443 billion.  In March 2012, cash holdings averaged $1,594 billion, up $151 billion for the year.  Commercial banks are still carrying a lot of cash on their balance sheets.  (According to Fed statistics, excess reserves in the commercial banking system averaged $1,362 billion in March 2011, and averaged $1,510 in March 2012.)

However, this cash figure for March 2012 is down from the $1,838 figure of September 2011.  So, commercial banks are holding less cash now than they were at certain times last year. 

One reason for this is that foreign-related institutions are holding a lot less cash than they were last year.  In September 2011, these institutions held almost $1.0 trillion in cash assets.  In early April 2012, this figure was down to about $650 billion.  A large portion of these assets were lent out to “related foreign offices” of the foreign-related institutions.  From March 2011 to a peak in February 2012, roughly $285 billion flowed from these foreign related institutions to their “related foreign offices.”  These flows were closely connected with the financial problems being faced in Europe.  With the efforts to resolve the debt crisis in Greece and with the lending down by the European Central Banks, the needs for cash from the United States lessened.  Lending to “related foreign offices” fell by almost $90 billion between early February and early April as the pressure from the crisis in Europe receded. 

We are not yet out-of-the-woods in terms of the problems in Europe and in terms of our need for stronger economic growth in the United States.  However, particularly concerning the latter, I feel better now that commercial banks seem to be producing more loan growth.   We can only hope that this loan growth will continue to modestly expand.  

Why Do I Need a Commercial Bank?

There is really no reason for me to be a customer of a commercial bank. 

Full disclosure: I am not the customer of a commercial bank. 

There is really little or no reason for many people…and businesses…and non-for-profit organizations…to be a customer of a commercial bank.

Here again, however, we are getting a bifurcation of the society. 

The world is splitting into those people, people with even a modest amount of wealth and some financial sophistication, who do not really need a bank and other people, who need only the very basic products and services offered by some kind of a banking organization.  And, in the latter case, a credit union is often the best place they could go to get the kind of products and services that they need.

Pushing this split along is…of course…the regulators. 

Allan Meltzer, in his delightful little book “Why Capitalism?”(Oxford University Press: 2012)   presents his two laws of regulation.  His first law of regulation: “Lawyers and bureaucrats regulate. Markets circumvent regulation.  His second law of regulation: “Regulations are static.  Markets are dynamic.  If circumvention does not occur at first it will occur later.”  The regulators, in their attempt to prevent a recurrence of 2008, are pushing the financial system well beyond what it once was.

Furthermore, advances in information technology are making circumvention easier and easier every day.  If finance is just information…which it is…and information can be presented in any form that can be useful, then financial information can be “sliced and diced” in any way that can serve the needs of a person or an organization.  And, it can be done almost instantenously.  This certainly will contribute to the ability of financial institutions to “circumvent regulation”.

The Financial Times devotes two pages in its April 10, 2012 issue to “shadow banking.”  To include the scope of this area, the Financial Times lists “alternative forms of finance.”  These alternative forms include leveraged finance, broker-dealers, hedge funds, money market funds, insurers, blue-chip lenders, mortgage servicing, peer-to-peer lenders, and governments. 

The paper even has a case study of what Siemens is doing to protect its money and to provide credit to suppliers as well as customers.  And, Siemens operation has been expanding over the past five years, rather than shrinking like many other “banking” organizations and now has a presence in such emerging markets as China, India, and Russia. 

Even Vikram Pandit, the chief executive officer of Citigroup, a form hedge fund manager, has stated that “One of the many unintended consequences of the brutal regulatory crackdown on banks is that there is now a massive incentive to be a shadow bank.”

But, there has also been a massive shift in terms of what is available to individuals and families on the financial front.  If you would have told be a few years ago that I would have no need of a commercial bank I would have said that you were delusional.  Now, as I said above, I do not do my “banking business” with a commercial bank. 

And, the situation is becoming even more desperate for the commercial banking industry.  The American Bankers Association is frantically fighting legislative bill S. 2231 which contains legislation that would allow credit unions to more than double the amount of business loans they could keep on their books.  The ABA argues that a vote for this legislation is a “vote against your community banks.”  ABA material goes on to say that “This special-interest bill allows aggressive credit unions to leverage their tax advantage to steal loans from community banks.”

It could be noted that credit unions are not taxed because they are mutual organizations…like mutual savings banks and savings and loan associations before them…but also have a lower cost structure that adds to their ability to attract business. 

The financial industry is changing and is changing dramatically.  Technology is speeding this change along, but so is regulation.  It is obvious that the press is now very aware of the innovations that are taking place.  More and more we see articles on mobile banking, new financial instruments being formed, products and services being offered in a different way, and global organizations penetrating more and more into regional and local banking markets. 

More and more people I talk with do not keep their business at a commercial bank any more.  Most of the young people (in their teens) I know are so sophisticated technologically that it is ridiculous to think that they will have anything to do with commercial banks.  And, if that is true, what will the case be for their brothers and sisters that are only five, let alone ten, years younger than they are?

The American Bankers Association admits that “Community banks account for a little more than 10 percent of the banking assets in our country….”  I cannot envision a scenario in which this percentage will increase…even if the credit union legislation mentioned above is defeated. 

In fact, I cannot envision a scenario in which the larger financial organizations do not become more and more like “shadow banks” rather than commercial banks.  Global competition will demand it.      

Prospects for the Fed, the Presidential Election, and the Dollar

The jobs report released on Friday was not good.  Furthermore, when one examined the decline in the unemployment rate to 8.2 percent, one saw that the rate fell, not because the labor market was getting stronger, but because the number of people actively seeking jobs declined.  That is, the labor market shrunk…under-employment rose. 

Immediately, speculation grew about whether or not the Federal Reserve would go in for another round of monetary easing.

This discussion closely follows upon the conclusions that the Fed would not engage in any more quantitative easing following the recent meeting of the board of governors of the Federal Reserve System and countless speeches and lectures from the Fed Chairman. (http://seekingalpha.com/article/467561-ben-bernanke-please-understand-me)

It is my view that the Fed will not engage in another round of monetary easing in the near future unless the economy or the banking system or the international financial system experiences a major shock.  A “not-so-good” report on the labor market will not be the trigger for such an injection.

The economy is growing, although it is not a very setting the world on fire. (http://seekingalpha.com/article/469671-gdp-growth-the-road-ahead-and-the-investment-climate)

The banking system is quiet and although commercial banks continue to disappear either through acquisition or FDIC closure, things seem to be peaceful with no expected surprises here.

Deleveraging in the private sector continues and restructuring continues to take place in housing, state and local government and the labor markets.  Again, there are no expected surprises in these areas.

And, it is a presidential election year.  It is highly unlikely that the Federal Reserve will engage in any actions that will leave it exposed to the criticism that it is playing politics.  In reality, Mr. Bernanke and the Fed has done about all it can to create a favorable economic climate in which President Obama can get re-elected. 

Given the lag-in-effect of monetary policy, there is very little that the Federal Reserve can do at this time to change the trajectory of the real economy before the election takes place in November. 

Therefore, I expect that the Federal Reserve will conduct a very benign monetary policy over the next six- to nine-months. (http://seekingalpha.com/article/472291-the-federal-reserve-was-quiet-in-q1-but-stands-ready-to-do-more) Otherwise, it will open itself…even more…to charges that it is playing politics and supporting the incumbent president.

Of course, the Fed cannot stand by if there is a crisis somewhere in the economy…in the banking sector…or in the financial markets…or somewhere else.  In such a case, the Fed will respond quickly and with sufficient force to avoid any breakdown.

Otherwise, I believe that the Fed will avoid any new initiatives this year.  Short-term interest rates will remain low.  The demand for money is weak and the Federal Reserve statistics indicate that there have been no new actions on the part of the Fed to keep them at current levels. 

If the real economy does pick up some speed and the demand for money begins to increase, some pressure may start to build for these short-term interest rates to rise.  My guess here is that if this scenario starts to develop, the Fed will allow these short-term rates to creep up.  In such a case, the Fed will not engage in a real active campaign to keep them in their current range. 

The key here is that the pressure for rates to rise will come from an economy that is strengthening.  This movement will be looked on positively by Federal Reserve officials.

The interesting market reaction to the Fed’s indication that it would not engage in another round of quantitative easing was that the dollar began to strengthen against the euro.  Through Thursday, last week, the dollar price of the euro had almost reached $1.30. 

Friday, with the release of the jobs report and the speculation that the Fed might engage in another round of quantitative easy, the dollar price of the euro rose slightly. 

This morning, the dollar rose again against the euro and I believe that this will continue if the Fed continues to maintain its current monetary policy stance through the spring and summer of this year.  In fact, I believe that the dollar will crack the $1.30 price against the euro and will continue down as the European Central Bank (ECB) continues to follow its present policy position.  (For more on this see my earlier post about the dollar breaking the $1.30 price level earlier this year: http://seekingalpha.com/article/371691-the-euro-drops-below-1-30.)

The dollar will continue to appreciate against the euro if the Fed continues to keep things pretty much the way they are at the present time because Europe, in my mind, is still in the middle of a mess.  One only needs to mention what is going on in Spain and Italy and Portugal...and then there are the French elections that we must go through over the next couple of months.

So, I see the Fed remaining relatively quiet for a while (except for Mr. Bernanke’s efforts to inform the world on what he and the Fed have done over the past five years or so); I see the economy continuing its recovery; I see some pressure starting to build on short-term interest rates; I see the value of the dollar rising against the euro; and I continue to hope for the absence of any unfavorable shocks to the world. 

If we can achieve this over the next year I believe that we will have been very fortunate.     

Two Drags on Economic Growth: Municipal Governments and Real Estate

Economic growth is expected to be modest over the next several years. (See my review, http://seekingalpha.com/article/469671-gdp-growth-the-road-ahead-and-the-investment-climate.) There are several structural reasons why growth may be constrained.  Today I would like to just highlight two of these factors that seem to be in the headlines these days.

The real estate area is one of these factors.  What has struck me in recent days are estimates of the number of foreclosures expected over the next three to four years.  The latest figures I have heard place the numbers in the hundreds of thousands for each year in this time span.  If one out of every five homeowners are “underwater” on their mortgages and if one out of every five individuals of working age are under-employed, the estimates of possible foreclosures in the near future do not seem excessive. 

This is a structural problem created by fifty years of government credit inflation affiliated with an excessive emphasis upon creating incentives for home ownership ultimately resulting in the subprime debacle of the past decade or so.  One of the constant conclusions of economics is that there are consequences of the incentives that you artificially set up. 

A corollary of this is that oftentimes the people these incentives are set up to help actually end up worse off in the longer run.  We now have another example to add to the economics literature of why this insight is true.  As the Nobel prize-winning economist Robert Mundell has recently stated, the “free lunches” that politicians promise voters in order to get elected often come back to harm the very people they were set up to help. 

The restructuring that is needed in the housing market will take years to accomplish.  And, accomplishing this restructuring will not just involve the generating new housing starts, housing prices hitting a bottom, and a growth in rental properties.  When you distort incentives for years and years, it takes a long time the economy to re-adjust. 

The restructuring will involve a continued shift of wealth from the less wealthy to the more wealthy…a continued increase in the inequality of the income/wealth distribution in the United States.  We see this occurring in many instances, like the wealthier picking up all sorts of properties at very cheap prices to build “portfolios” of “fixer-uppers to fill with tenants. (http://www.nytimes.com/2012/04/03/business/investors-are-looking-to-buy-homes-by-the-thousands.html?_r=1&scp=2&sq=motoko%20rich&st=cse)

The same thing might be said about what has happened to municipal governments.  There are some real disasters being confronted in this area at the present time.  Take Detroit…please.  And, Stockton, California.  And, Harrisburg, Pennsylvania.  And, Jefferson County, Alabama.

During the fifty years or so of credit inflation that was particularly successful in inflating property prices, local municipal governments thrived.  Not only did the governments themselves thrive, but the municipal labor unions thrived to the extent that public labor unions came to represent more workers in the United States than did unions in the area of manufacturing.

Labor unions could thrive in this sector of the economy because they were a monopoly and because it was easy to pass along the increase in salaries and benefits to property owners.  Property owners had the best “piggy bank” going during these wonder years, the “piggy bank” being their homes whose prices were inflating far beyond the general level of consumer prices.  Furthermore, these municipalities found an almost unlimited financial market to issue debt into and, if any questions arose about their financial condition there were always accounting gimmicks that could be used to make “things” lot better.

The problem is…to draw on the analogy presented by Warren Buffet…that the tide has gone out and this has revealed the fact that some of the people in the water were not wearing bathing suits!

Times have changed for municipal governments and this means that there must be a substantial restructuring of how these organizations do business.  Detroit is a prime example.  Here the city government became the welfare agency of the population and the population ceased to work.  This was not lost on a lot of people as the population of Detroit declined from over two million citizens in the 1950s to less than eight hundred thousand today.  The “free lunch” is over for the people of Detroit and those left in Detroit do not want to see their welfare go away. 

Again, we see that the problem of getting back to higher levels of economic growth is that a major restructuring has to take place in municipal organization and finance.  Major restructurings take time and resources.  And, a situation that has been created over many, many years cannot be turned around on a dime. 

Economic growth is going to continue in the United States but it is not going to be robust.  The past fifty years has created many dislocations in the country that must be worked out.  Those discussed today are just two of the many.     

No Enthusiasm for Mergers in Q1: Is Coty Bid for Avon a First to "Jump in the Pond" to Get Things Going?

Mase: Economics and Finance.  April 2, 2012

No Enthusiasm for Mergers in Q1: Is Coty Bid for Avon First to “Jump into the Pond” to Get Things Going?

Enthusiasm for mergers or acquisitions in the first quarter of 2012 was low as CEO confidence for doing deals seemed to be missing.

Corporations are still sitting on “tons” of cash and longer-term interest rates, across the board, remain exceedingly low and funds are available.  Yet global M&A activity in the first quarter of 2012 was at the lowest level since the first quarter of 2003. (http://professional.wsj.com/article/SB10001424052702303404704577311683850080836.html?mod=ITP_moneyandinvesting_4&mg=reno64-sec-wsj)

The biggest concern in the executive suite seems to be that old demon “uncertainty.”  There is uncertainty about the economy; there is uncertainty about where President Obama stands on business; there is uncertainty about events in Europe and the world; and there is uncertainty about the regulatory and legal environment.

This “uncertainty” is one of the contributing factors to fact that there is not more robust economic growth. (See my post, http://seekingalpha.com/article/469671-gdp-growth-the-road-ahead-and-the-investment-climate.) For people to commit, people must have confidence that what they are doing has a good chance of succeeding.

Attitudes seem to be modifying a little.  If anything, as someone has described it, there is a general lack of bad news. 

Not too encouraging…but, this can be alright too.

The economy is growing, there are some encouraging signs, here and there, and, although there are still major things to watch out for, people do not seem to be expecting major shocks to the system.   Monetary policy is relatively benign at the present time and is expected to remain so through the fall election.  But, the monetary authorities are prepared to respond strongly against any major shock to the economy if such a shock occurs. (http://seekingalpha.com/article/472291-the-federal-reserve-was-quiet-in-q1-but-stands-ready-to-do-more.)

Within this environment, more and more discussions about acquisitions seem to be taking place between organizations.  Ideas and plans that had been put on the shelf seem to be back in people’s minds again. 

Especial interest seems to be focusing, not surprisingly, on Europe.  The financial crisis of the last few years has drained the continent in many ways and there seem to be quite a few potential targets available at rather good prices. 

Along this line, just recently the UK’s NDS Group Ltd. was picked up by Cisco Systems, Inc., and the Netherland’s TNT Express NV was acquired by United Parcel Service, Inc.

Starting out a new quarter, following a quarter that saw strong stock performances, we hear that Coty, Inc. of Europe is making a bid for Avon Products, Inc., even though Avon is more than twice the size of Coty.

The importance of this is not so much the deal, itself, but the fact that action in this area seems to be increasing.  The economy is growing, monetary policy is permissive, cash is available, the stock market has been strong recently, and it is spring!

“The main thing to really resolve is the absence of confidence, so you need a couple of people to jump into the bath and say the water isn’t so bad in here.”  This is from Daniel Wolf, a partner in the law firm of Kirkland & Ellis.

Basically, some people have to be brave enough to take the plunge!  Then others may follow.

A pick up in M&A activity may not cause economic growth to increase…in fact, I don’t believe that it will…but it may help to spread more confidence around which will lead people to buy more common stock or pay off more debt.  Each of these things will help to confidence to grow and expand…both of which are necessary for the economy to continue on its upward path. 

I would expect this to be particularly helpful in causing the price of stocks to rise.  The reason for this is that historically, a good time to buy common stocks is when people and businesses are cautious and exhibiting a disciplined approach to what they are doing.  It is a good time to acquire when people and businesses are being very selective. 

Generally, this means that prices are low and attractive acquisitions can be made.  It also means that not everyone is jumping into the pool so that the level of the entire pool is rising.  That is, that people and businesses are just buying things without any real reason except that things seem to be going up. 

Let’s keep our eyes on those corporate cash hoards to see whether or not companies are moving more aggressively into acquisition mode.  My belief is that if the pace of M&A activity picks up, this will be a show of confidence that will benefit us all.   

The Federal Reserve Was Quiet in the First Quarter

In the first quarter of 2012, the Federal Reserve was very quiet.  The reserve balances that commercial banks held at the Fed actually declined by about $4.0 billion during the quarter to total $1.563 trillion on March 28.

Securities held by the central bank declined by slightly more than $15.0 billion as the Fed’s portfolio of Treasury securities, Federal Agency securities, and mortgage-backed securities all fell during the period.  Over the last four weeks of the quarter, very little took place in the Fed’s holdings although, in aggregate, there was a small decline.  

The factors supplying reserve funds to the banking system actually declined by about $48.0 billion but this was offset by around $44.0 billion in factors absorbing reserve funds.

The biggest item impacting the decline in reserve funds being supplied was the reduction in Central Bank liquidity swaps that occurred as the financial crisis in Europe resided and most of this took place in the last four weeks of the quarter. This was offset on the liability side of the Fed’s balance sheet by a number of operational factors, none overly significant.

These data just reconfirm the signals that Chairman Bernanke has given Congress, financial markets, and the academic world about the current stance of monetary policy.  The Federal Reserve is not doing a lot right now, but will not back off from the quantity of reserves it has injected into the banking system over the past two years, and stands ready to do more if the need should arise.

And, short-term interest rates continue to remain exceptionally low.  Since the Fed is doing little or nothing to supply more reserves to the banking system, the fact that the short-term interest rates are staying so low implies a lack of strength in the demand side of the market.  This, I believe, is an important thing to keep our eyes on because if the demand for funds begins to pick up, this will put pressure on short-term interest rates and the Fed will either have to step in to prevent this rise because of economic or banking reasons, or, let the rates begin to increase.  This is an area to watch.    

This all sounds pretty dull, but…the central bank really likes things dull!

For one, only 16 banks were closed by the FDIC in the first quarter of 2012, compared with 18 banks being closed in the last quarter of 2011.  We will have to wait for over a month and a half before we know how many more banks left the banking system through mergers and acquisitions.  Last year, the banking system lost, on average, 60 banks per quarter and only 23 of these were banks that were closed by the FDIC.  The number of commercial banks in the banking system continues to decline, but in an orderly and calm fashion.  Dull is good!

Economic growth continues, but it is not exceptional. (For more on this see my post http://seekingalpha.com/article/469671-gdp-growth-the-road-ahead-and-the-investment-climate.) There is not too much more that the Fed can do in terms of stimulating more rapid economic growth, but it does hope to contribute to a turn-around in the housing area. 

But, the economy is growing, and, baring shocks related to gas prices, a collapse of the eurozone, or an economic slowdown in China…among other things…it should continue to grow over the next several years, although the expansion will not be robust. 

This is not all bad since many households and businesses are still reducing debt loads and trying to get their finances in order. 

The problem is in the employment area.  It is not just that the unemployment rate continues to stay too high, it is that under-employment still hovers around 20 percent.  A reason the unemployment rate might not drop too much over the next six to twelve months is that if the job market becomes more active, people who are now not considered to be a part of the labor force will re-join the labor force hence helping to keep unemployment rate higher than desired.

One thing is apparent and that is the Fed does not seem to be doing anything dramatic about getting the unemployment rate done more rapidly in advance of the Presidential election in the fall.  Given the lag-in-effect of monetary policy, the Fed has done just about all it can to achieve lower unemployment numbers this summer and fall. 

This may be one reason why we are not seeing the announcement of another round of quantitative easing.  The current Fed has already been accused of being one of the most “political” central bank administrations ever.  Announcing another round of quantitative easy at this time would only exacerbate those cries.  And, in my mind, would be able to achieve little or nothing in terms of a more vibrant economy and labor market through the end of the year. 

Thus, I believe the Fed will remain relatively benign over the course of 2012.  Again, dull is good when it comes to central banking.  But, this doesn’t mean that the central bank will not act during the year if there is a real need for action, coming from the banking sector, the economy, Europe, or elsewhere.